Many people own substantial IRAs and have the bulk of their investment portfolios in IRAs. Some of these investors might not realize there are investments that are prohibited from IRAs and others are allowed but incur tax penalties. The issue of how to invest an IRA is more important in today's climate, because "hard assets" and other nontraditional assets—those that investors prefer today—are primarily those prohibited or discouraged in IRAs.

IRA investment disincentives fall into three categories. There are prohibited investments, taxable investments or transactions, and prohibited transactions.

The prohibited IRA investments are labeled “collectibles.” When an IRA purchases a collectible, the amount used to make the purchase is treated as distribution to the owner. It is included in the owner's gross income, and if the owner is under age 59½ and does not qualify for one of the exceptions, a 10% early distribution penalty is imposed on top of the income taxes. In addition, there is a penalty each year the IRA continues to own the prohibited investment.

Collectibles are defined in the tax code as works of art, antiques, rugs, stamps, coins, metals, gems, and alcoholic beverages. The IRS is allowed to define other items as collectibles but has not done so.

Note that an IRA may purchase securities of firms that produce collectibles, such as mining companies and alcohol producers or distributors. But the IRA may not purchase the collectibles themselves.

There are other investments an IRA may own, but those investments could cause the IRA to owe income taxes on income from the investments or the owner might be taxed as though distributions were made.

An IRA is most likely to be taxed when it earns unrelated business taxable income (UBTI). The UBTI rules apply to all qualified retirement plans, not just traditional IRAs. If an IRA earns UBTI exceeding $1,000 it must pay income taxes on that income. The IRA might have to file Forms 990-T or 990-W. It also must pay estimated income taxes during the year if the UBTI exceeds $500.

The IRA owner essentially will be taxed twice on UBTI. The IRA will be taxed on the income. Subsequently, the owner or beneficiary will be taxed on distributions of that income. There is no deduction or credit available to the owner for UBTI paid by the IRA, and the tax on the IRA does not increase the tax basis of the IRA.

The UBTI rules are supposed to prevent a tax-exempt entity such as an IRA from unfairly competing with tax-paying businesses. The rules are fairly broad, however, and apply to situations in which the IRA is not operating a business. An IRA potentially has UBTI if it does any of the following:

 operates a trade or business,

 receives certain types of rental income,

 receives certain types of passive income from a business entity it controls,

 invests in a pass-through entity, such as a partnership, that conducts a business, or

 uses debt to finance investments.

A "trade or business" is any activity carried on for the production of income from the sale of goods or performance of service. Any business is considered unrelated to the exempt purposes of an IRA or other retirement plan. Fortunately, the tax code specifically excludes certain types of income from the definition of trade or business income for UBTI purposes. The exempt types of income include interest, dividends, capital gains, and profits from options transactions. Royalties also are generally exempt.

Even exempt income, however, can be converted into UBTI.

Real estate rental income generally is exempt from UBTI, but becomes UBTI if the amount of rent is computed as a percentage of the tenant's profits.

Controlling a business entity also can convert exempt income into UBTI. When an IRA has greater than 50 percent control of a business entity, any rent, interest, or royalties paid by the entity to the IRA is UBTI if the payments have the effect of reducing the business income of the entity. Another way to look at this rule is that if the business entity deducts the payments to the IRA, they are UBTI to the IRA.

When an IRA owns an interest in a pass-through business entity (partnership or limited liability company), the IRA's share of the entity's income is UBTI. Pass-through entities generally do not pay federal income taxes. Instead, their income and expenses are passed through to their owners' income tax returns.

This rule most often trips up individuals who invest in master limited partnerships (MLPs) or real estate partnerships in their IRAs. MLPs are traded on major stock exchanges, and many people think of them as being the same as corporate stock. In fact, these are partnership units, and the income and expenses of the partnerships pass through to the owners at tax time. Individuals generally are urged not to purchase MLPs through IRAs.

It is not illegal to own an MLP through an IRA. The ownership, however, triggers the UBTI rules and the requirement to possibly file a version of Form 990 and pay estimated taxes. There is no tax advantage to owning MLPs through an IRA. Some tax advisors recommend taking the easier and cheaper route of reporting any IRA-owned pass through items on the individual tax return instead of filing a separate Form 990 for the IRA.

An IRA also has UBTI when debt is used to finance investments. Any type of income can become UBTI when debt is used to finance the property that generates the income. For example, if an IRA receives a margin loan from the custodian or broker, income generated by the securities purchased with the loan proceeds would be UBTI. Real estate mortgages also are debts that convert exempt income into UBTI. An IRA can own real estate and earn rental income, and that rental income will be tax deferred. If the real estate is financed with a mortgage, however, the rental income becomes UBTI.

The prohibited transaction rules are the final category of taboo investments. The rules are fairly detailed and can get complicated. Generally they prohibit transactions between the IRA and its owner or a person related to the owner (including businesses).

The penalty for violating the prohibited transaction rule is severe. The entire IRA will be considered fully distributed when the prohibited transaction was made. The IRA owner must include its full value in gross income, regardless of the amount of the prohibited transaction. If the owner has multiple IRAs, only the IRA that engaged in the prohibited transaction is penalized. Other IRAs escape the penalty unless they also engaged in prohibited transactions.

It is easy to state the prohibitions in clear, plain English: No deals are allowed involving the IRA and the owner or a person related to the IRA or its owner. Yet, there are some "prohibited transactions" allowed by IRS regulations or rulings, and IRA owners can receive waivers from the Department of Labor for specific transactions.

A detailed discussion of the prohibited transaction rules would be too much for this posting. While it is possible for an IRA to engage in transactions with the owner’s small business, real estate, or other interests, such transactions should not be considered without good tax or legal advice.

IRAs do not have complete investment freedom. IRA owners who prefer investments other than publicly-traded stocks and bonds and mutual funds need to be wary of the potential pitfalls.

Bob Carlson is editor of the monthly newsletter Retirement Watch and the web site www.RetirementWatch.com. He also is author of numerous books and reports, including The New Rules of Retirement and Invest Like a Fox…Not Like a Hedgehog.